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Stresses in the U.S. Mortgage Credit Markets (Part 2)

22 Mar 07

Stresses in the mortgage markets have escalated sharply in the first quarter of 2007, and this is expected to put additional downward pressure on housing market activity in 2007.

Stresses in the mortgage markets have escalated sharply in the first quarter of 2007. These stresses are connected with the following four interrelated developments:
  • A large jump in debt servicing and property tax liability costs for many borrowers, stemming primarily from the "ARM reset" issue. As a result, we have seen a significant jump in mortgage delinquency and foreclosure rates, especially in the subprime lending category. The distribution of these increases was uneven across different states.
  • Rising foreclosure rates, leading to increases in the annual flow of housing inventory coming back into the housing market.
  • A sharp tightening of mortgage credit standards reported by commercial banks reporting to the Federal Reserve.
  • Disintermediation, or a reduction in liquidity and funding sources in the mortgage credit supply markets, mainly impacting niche subprime and Alt-A lenders.

We discuss these developments below, then provide an update to the Global Insight housing forecast for 2007 and 2008.

The "ARM Reset" Affordability Problem

The ARM (adjustable-rate mortgage) reset and related affordability issues are probably the single-most important source of stress. The share of mortgage originations in the form of ARMs jumped from about 17% in 2002–03 to about 32% in 2004–05. As a result, the share of ARMs in total mortgages outstanding rose sharply over the business cycle, reaching perhaps 25–30% by the end of 2006. ARMs became extremely popular when short-term interest rates dropped to historically low levels from 2002 to 2004, as the Federal Reserve attempted to jump-start the economy from an extended period of sub-potential growth. In addition, many mortgage lenders offered "teaser rates" that were below the market-indexed rates. This enabled more borrowers to enter the housing market, particularly subprime borrowers, but also provided credit for mezzanine-type mortgage credit (i.e., neither prime nor subprime, referred to as "Alt-A" credit risk). A relatively large share of Alt-A credit (about 15%) was utilized for housing investment—i.e., homeowners buying second properties either for vacation, retirement, or pure investment reasons. Most of the growth in the ARM mortgage credit was driven by a combination of subprime and Alt-A credit.

The volume of ARM credit outstanding is not known for certain. Growth in this type of credit was compounded not only by the rising share in mortgage originations, but also by the fact that the average ARM loan is much larger than fixed-rate loans (by a factor of about 1.5 in 2003–06). Thus, the share of ARM mortgage debt in total debt outstanding was probably close to 35% at the end of 2006—this translates into roughly $3.5 trillion of single-family mortgage debt, out of a total of about $10 trillion.

The rate-reset problem is connected not only with the expiration of "teaser rates," but also the fact that market-indexed rates have also moved up over this period. Since some loans have caps on the rate increment, they may reset several times over a relatively short period of time. Recent estimates from Fannie Mae indicate that the reset volume related to outstanding mortgage-backed securities would be about $683 billion in 2007 and about $844 billion in 2008. Adding in rough estimates for "unsecuritized" mortgages, Fannie Mae estimates roughly $1.1–2.2 trillion of reset volume in 2007, followed by $1.4–2.4 trillion in 2007. The share of subprime loans in the reset volume is estimated to be about 47%, while the share of Alt-A debt is about 25%. Thus, a very large share of ARM mortgage debt—about 72%— is not rated as "prime."

Taking the mid-point of the Fannie Mae estimates on reset volume—and assuming that the average reset on interest rates is approximately 2 percentage points—that would translates into about $35 billion in additional debt servicing sequentially in 2007 and 2008 (and reduction of 0.3% of personal income sequentially each year). However, higher municipal property tax assessments compound the problems related to increased debt-servicing stress. There is a wide range of methods across municipalities for assessing property taxes, but periodic market value assessments are typically used as a guise to increase effective municipal property taxes.

The macro impact of the ARM-reset affordability problem, while far from negligible, is not overwhelming. A more troubling issue is the regional and distributional impact across states and households that have been disproportionately impacted by the recent cyclical downturn or have seen rapid rises in house prices; states as diverse as Minnesota, California, Michigan, and Nevada have reported out-sized jumps in mortgage payment defaults. The regional and cross-income distributional impact of the ARM-reset problem could be significant.

Rising Mortgage Delinquencies and Foreclosures

Sharp increases in delinquency rates, particularly on subprime mortgages, in the fourth quarter of 2006 set off alarm bells in mortgage credit and equity markets. The delinquency rate on all mortgages rose from 5.1% at the end of 2005 to 5.3% at the end of 2006, but on subprimes the rate jumped from 11.6% to 13.3%. Subprime delinquency rates jumped across all regions, but in the North Central region they rose to a record 16.8%. The inventory of loans in foreclosure at the end of 2006 was reported by the Mortgage Bankers Association (MBA) at about 1.19%, or 602,000 loans( We estimate total ARM debt at the end of 2006 at $3.5 trillion. With the average loan size of $260,100, this translates into about 13.4 million loans. Fixed-rate debt was about $6.5 trillion, or with an average loan size of $173,400, about 37.4 million loans. That gives a grand total of about 50–51 million loans at the end of 2006.), compared with 0.99% at the end of 2005, or about 475,000 loans. According to MBA back-of-the-envelope estimates, roughly one-third of these foreclosures will wind up back in housing inventory during the next year, or about 201,000 units in 2007, compared with about 158,000 in 2006. The remaining loans are restructured to make them current.

The previous peak in the overall foreclosure rate was 1.51% in the first quarter of 2002. The foreclosure rate will likely climb fairly rapidly over the next two years, and will likely exceed the previous peak. If we assume, conservatively, that the foreclosure rate moves up to 1.60% by the end of 2007, then the flow of inventory moving back into the housing market would increase to about 279,000 units in 2008. Thus, the flow of sales inventory moving back into the housing market is rising, from an estimated 158,000 units in 2006 to about 201,000 in 2007 and 279,000 units in 2008. This increase in the supply of homes will put some extra stress on the housing market during 2007 and 2008.

Sharp Tightening of Mortgage Credit Standards by Large Commercial Banks

The Federal Reserve senior loan officer survey in early February reported a sharp upward spike in mortgage credit standards to levels not seen since the last recession in 2000/01. This tightening process is expected to get worse in 2007, so it is very likely that the change in credit standards is likely to exceed the tightening that we saw prior to the 2001 recession. There is anecdotal evidence that the tightening of credit standards has impacted not only subprime borrowers, but also the mezzanine credit risk (or Alt-A) between prime and subprime borrowers.

This tightening of credit standards will disqualify a significant number of new borrowers from the mortgage marketplace. Just how many is difficult to say. At the end of 2006, subprime and alt-A loans accounted for roughly 72% of ARM debt outstanding—that is roughly $2.5 trillion in debt, or 25% of the total mortgage debt outstanding. This represents about 9.6 million loans, or roughly 19% of the total number of mortgage loans outstanding. Assuming that roughly 20% of mortgage originations in 2006 were in these categories (subprime and Alt-A), this represents an annual flow of about 550,000 new loans. Based on the fact that the subprime delinquency rate jumped to 13.3% at the end of 2006, and is likely to move much higher, the number of borrowers disqualified by a commensurate rise in credit standards would be at least 15%—about 83,000 borrowers. It would not be unreasonable to expect a more-amplified credit squeeze under current market conditions, i.e., about 20%, thereby pushing the number of disqualified borrowers up to about 110,000. In other words, one out of every five subprime and Alt-A borrowers that qualified for credit in 2006 would be disqualified in 2007 and 2008. A more-severe credit squeeze could easily push that number up to 140,000.

Disintermediation Due to Severe Funding Problems at Niche Subprime and Alt-A Lenders

In addition to the impact of higher credit standards on the mortgage market overall, we need to adjust for the volume of credit that will disappear due to disintermediation of the niche lenders that either become insolvent, or see a significant reduction in new business due to constrained funding. This effect is probably the most difficult to calibrate. Based on mortgage purchase origination volume by subprime lenders of about $80 billion in 2006 (or about 40% of total subprime origination volume), and making the moderate assumption that roughly 20% of the credit disappears, that implies roughly 63,000 fewer mortgage purchase loans in 2007. With respect to the Alt-A players, based on mortgage origination volume of about $52 billion in 2006 (about 25% of the total Alt-A volume) and assuming that about 10% of this market volume is impacted, that translates into about 21,000 fewer mortgage purchase loans. All told, there would be roughly 84,000 fewer loans in 2007, and about the same number in 2008. Since many of these originations were repackaged into securities and sold to overseas investors, often bundled with prime mortgage-backed securities, the reaction of overseas investors in terms of potential reduction in the supply of credit to subprime and Alt-A markets, and mortgage markets overall, is very difficult to assess.

Estimated Supply- and Demand-Side Impacts on the Housing Market





Supply-Side Effects


Foreclosure Inventory Reverted to Market (Next Year)




Change in Supply





Demand-Side Effects


Increase in Disqualified Borrowers




Disintermediation: Reduced Funding, Bankruptcies, and Exits




Reduction in Demand




The Subprime Market and the Updated Housing Forecast

How have the problems with the subprime market affected the housing forecast? When we updated the forecast in early March, we lowered housing starts by about 62,000 (or 4%) and home sales by about 52,000 units (or 0.7%), mainly because of the problems in the subprime mortgage market. Since releasing the forecast, we have acquired updated information on delinquencies and foreclosures trends. We also have a better picture of how the problems in the subprime market will affect the rest of the economy. Based on this new information, we will further lower both our housing starts and home sales forecasts by about 50,000 units. We will also lower our forecast for house prices, so that the median price of an existing home falls by 4–5% in 2007 (instead of 3%, as in our current forecast). In our updated housing forecast, we expect residential investment to chop 1.1 percentage point off of GDP growth in 2007 (compared with about 0.9 percentage point off in last month's forecast); about 0.2 percentage point of this will be because of the subprime woes. We do not expect the housing market to turn around until early 2008.

by Brian Bethune and Patrick Newport

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